Emma Wall: Hello, and welcome to Morningstar. I am Emma Wall and I am joined today by Alastair Gunn, manager of the Jupiter High Income Fund to give his three stock picks.
Hi, Alastair.
Alastair Gunn: Hello.
Wall: So, what's the first stock today?
Gunn: The first stock is Royal Mail (RMG), and the reason I like Royal Mail is that dividends are big risk across the market generally and Royal Mail has a very strong looking balance sheet. It's got virtually no debt. It's got a big pension fund surplus today. It has a lot of surplus property on its balance sheet and the dividend is round about two times covered at the moment. On a cash basis, it's less covered than that at the moment, but that builds very rapidly over the next couple of years.
Wall: It was quite controversial stock when it listed, and there were sort of headlines that suggested that shareholders had perhaps being swindled because the price was so high. It was a national asset and we should have got more for it. Obviously, their share prices come down quite a lot since then. Do you think it's on fair value? Is it undervalued?
Gunn: No, I think it's very definitely undervalued at the moment, but when it was floated, it was floated with the seven-year regulatory framework and it was within that framework. It was going to be allowed guaranteed returns and the returns today are much lower than the allowable returns in the future and that was to allow for investment in automation and to live with the fact that there is universal service requirement.
Everybody in the country is entitled to a mail delivery service. And yet particularly in the more remote areas of the country that basically is a loss-making service.
So, you got to fund that some way. And what's happened recently is we had a regulatory review and that cost into some uncertainty whether the current framework will last or not.
Now, to my mind it will last. I think that will be cleared up later this year. And that means that we'll have a much securer future in terms of growth in earnings going forward. And the reason I think it's going to be unaffected is because now delivery costs in the U.K. are amongst the lowest in Europe, service standards are amongst the highest.
And if you are a regulator, what are you trying to do? You need to make sure that that universal service obligation can be delivered and only sort of two, three year ago before Royal Mail was privatised, it was on its knees financially. It was in danger of going bust.
So, in order to provide a viable future for Royal Mail, it has to have a framework similar to one that we have before and I think will be reconfirmed later this year.
Wall: And what's the second stock today?
Gunn: The second stock is BP (BP.), little bit controversial in the context of plunging oil prices. But my view there is that today you can buy BP with about an 8% dividend yield and I think that dividend yield will prove to be sustainable. At the moment it's uncovered. If you look back over the last 12 months, the average oil price was about $50 and in order for BP's dividend to be covered by its cash income stream, it needed about $85 a barrel.
So, it's well off of where it needs to be at the moment. But it's pushing deflation into its supply chain forcing down the cost of all of the services that it buys in. And I think that's one part of the story.
The other part of the story is the fact that I think we're going to see the oil price pick-up quite quickly, and that's partly because we've had a bit of a supply issue. The supply will start to fall away because the amount of production coming out of the U.S. from the shale industry has a very high natural decline rate. But also existing wells in other parts of the world also have quite a high natural decline rates.
The market will move back into balance quite quickly, and I think if you hear any noise around production cuts from the OPEC nations and that kind of thing is making a lot of headlines at the moment with Russia and Saudi and sort of talking about production cuts.
Then I think the oil price spikes up quite quickly and we moved to a world where people think that that dividend is sustainable. And on that basis I think the BP share price will be a lot higher than where it is today.
Wall: And what's the third and final stock?
Gunn: The third stock is Esure (ESUR). This is a motor insurer. Over the last two, three years motor insurance rates have fallen very dramatically down over sort of 30%, in the last six months they've been picking up and part of the reason for that is that a number of motor insurers are not making money by writing business of where rates had got to.
And the transfer mechanism the way in which we buy motor insurance now is increasingly through comparison websites…
Wall: Aggregators, yeah.
Gunn: Yeah, so Gocompare and Moneysupermarket and so on. And that accelerates the process of deflation. But when you start to see prices go up, it actually works the other way and I think that we will see surprises in terms of analyst expectations for how quickly motor insurance rates can go back up again. And the nice thing from an insurance investors perspective is that you get a nice dividend yield along the way, the stock yield is over 5% and that's a growing yield.
And then on top of that there is another dimension. They own Gocompare this aggregator site and it's only kind of quoted peer is a company called Moneysupermarket. And Moneysupermarket is valued on about 23 times earnings at the moment and Esure's valuation is around about 12 times earnings. And I think over time there will be a kind of some of the parts valuation approach to looking at Esure and this stock will be re-rated accordingly.
Wall: Alastair, thank you very much.
Gunn: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
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